45 The Romanian Economic Journal The relationship between financial and tax accounting in Albania Ilda Duhanxhiu 1 Valbona Kapllani 2 Typically ‘income tax’ laws rely on financial accounting data to determine the taxable income of a business entity, although financial and tax accounting have different goals and requirements. The purpose of this paper is to explore the relationship between financial and tax accounting rules in Albania. The study employs a mixed methodology, comprising a review of the legislation, institutional framework and context, and semi-structured interviews with accountants, academics and institutional players. By reviewing the development of this relationship during the past 20 years, we aim to identify and explain the major divergences at present between two sets of rules. Keywords: accounting regulations, IFRSs, taxable income, developing countries JEL Classifications: M41, M48 1. Introduction Over the past two decades, as many other developing countries, Albania has strengthened its accounting regulations as part of broader programs of the market-oriented regulatory reform. The central element of this process, especially in the second decade, has been the 1Ilda Duhanxhiu ,PhD Candidate, Department of Accounting, Faculty of Economics, University of Tirana, Albania, [email protected] 2Valbona Kapllani , PhD, Lecturer at the Department of Accounting, Faculty of Economics, University of Tirana, Albania, [email protected] Year XV no. 43 March 2012 46 The Romanian Economic Journal introduction and adoption of IFRS 3s following the widespread IFRSs adoption in the EU. International accounting literature provides evidence that IFRSs improve accounting quality and potentially reduce the cost of equity capital (e.g. Barth et al., 2005; Bushman et al., 2006; Daske et al., 2008). However the adoption of IFRSs has raised several questions and concerns, especially regarding its impact on the tax accounting and vice versa. Accounting rules and tax rules are two concepts developed by different authorities and used by heterogeneous groups of users serving different purposes. IFRSs are formulated to accomplish the objectives of financial reporting 4 including providing information that is useful to investors, creditors and analysts in making rational investment and credit decisions. Tax rules (e.g. income tax law) are formulated, in part, to encourage certain kinds of behavior by taxpayers on the premise that such behavior is good for the economy as a whole. So, contrary to financial accounting, tax accounting serves only to one user, the government (tax offices). Some researchers argue that alignment of the tax and financial accounting rules could improve the perceived equity of the tax system, reduce tax compliance cost, and enhance tax compliance levels. While others are convinced that full convergence of commercial and tax accounts cannot be achieved and should not be the aim. The main focus of this paper is a systematic examination and critique of the development of financial and tax accounting in Albania from the 1990s until the present day. This period can be considered the formative years of the accounting profession in Albania. The historical development of the relationship between financial and tax and 3IFRS as used in the paper should be taken as International Financial Reporting Standards issued by the International Accounting Standards Board and International Accounting Standards issued by its predecessor, the Board of the International Accounting Standards Committee. 4We use financial reporting and financial accounting as interchangeable terms. Year XV no. 43 March 2012 47 The Romanian Economic Journal accounting is characterized by a weak position of the accounting profession and the intervention without regard of tax law to either accounting principles or existing accounting practices. The tradition of financial reporting in Albania is still quite young compared to some other countries. It is also noteworthy that until 2008, when the implementation of IFRSs entered in force, financial reporting in Albania was, almost, entirely guided by tax rules. Although it is a well-known fact that taxation depends on financial accounting, this relationship it is not an easy one. The examination of the relationship between accounting and taxation provides insights for national regulators and policy makers to make better informed policy decisions. The paper is organized as follows: the next section provides a theoretical overview of the objectives of financial and tax accounting. Section 3 reviews in detail the development of Albanian accounting law and tax regulation during the past 20 years. The fourth section presents and analyses actual divergences between financial and tax accounting in Albania. This analysis is supported by interview work with accountants, academics and other institutional representatives. The final section concludes. 2. Overall of Financial and Tax Accounting Objectives and Users Accounting is often called the language of business and as languages evolve in response to the changing needs of society, so does accounting. According to King (2006) tax accounting is developed as a distinct dialect from financial accounting due to public policy and business issues. Although at the beginning of their “relationship”, financial accounting and tax accounting were in some accord, today the accountants have to work hard to reconcile their respective conflicting objectives. Accounting rules and tax rules are two concepts developed by different authorities and serving different purposes. Year XV no. 43 March 2012 48 The Romanian Economic Journal It is the contrariety of financial accounting and tax accounting objectives which make attempts to reconcile the two difficult. While the IFRSs are formulated to accomplish the objectives of financial reporting, tax rules are formulated, in part, to encourage certain kinds of behavior by taxpayers. The objective of the general purpose financial reporting, as set forth in The Conceptual Framework for Financial Reporting issued by the IASB in September 2010, is to provide financial information about the reporting entity to existing and potential investors, lenders and other creditors and aiding their decision making process. In contrast, the objective of tax accounting, as part of the tax system is to protect the public treasury and improve the amount and timing of tax collections. Government imposes taxes to raise revenue, redistribute wealth and encourage economic activity. Thus, on one side, taxation represents a powerful instrument for government economic and social policy, and on the other side, it makes the government an involuntary partner of the business entity. For the business entity, tax accounting is an area of financial accounting in which the entity report to the tax authorities. The tax law may change every legislative session. Financial accounting based on IFRSs, involves a certain measure of judgment, certain flexibility in the assessment of entity’s transactions in order to provide a true and fair view. In contrast, taxation is guided by the interest of equal treatment of all taxpayers. Thus, flexibility cannot be allowed to the same extent; uniformity is necessary to provide a reliable basis for tax assessment. Several studies have explored the relationship between financial accounting and taxation and the possible implications related to the IFRSs adoption. According to Nobes (2003), current international accounting standards setters pay little regard to tax implications and would be unlikely to add taxes to the list of considerations and pressures they must take on board already. Alley and James (2005) concluded that the relationship between accounting and taxation is an Year XV no. 43 March 2012 49 The Romanian Economic Journal evolving one, and countries should not be developing tax policy and practice in isolation. Freedman (2008, 2004) demonstrated that full convergence of commercial and tax accounts will not be achieved and should not be the aim. According to her the neutrality of taxation maybe a desideratum but governments will not wish to give up the ability to use tax as an economic tool. Gielen and Hegarty (2007) suggest being very cautious since when it comes to drafting tax accounting rules based on IFRSs, all of the major issues arise out of details on technical accounting matters. Hanlon, Maydew, and Shevlin (2008) demonstrated that increasing book-tax conformity results in earning that are less informative. In conclusion, there is much debate on the extent to which financial accounting and tax accounting should be related. The two sets of rules differ because they are intended to achieve different objectives. 3. The Development of Albanian Accounting and Tax Law In early 1990s as many other countries of Central and Eastern Europe, Albania began its process of transition from a command economy to a market economy. An important component of this process was the accounting and tax reform aimed to adopt the accounting and tax practices of the developed economies through the introduction of new accounting and tax legislation, improvement of accounting education, and the creation of new accounting and tax institutions. The development of accounting law In the former socialist economy, the role of accounting was limited to the statistical figures needed for the central authorities. There was no public disclosure of accounting information and no independent accounting profession. So the two major objectives